Last week the US Bankruptcy Court for the District of New Jersey issued an opinion in a case captioned Kemp v. Countrywide Home Loans, Inc. This case looks like the first piece of evidence in what might turn out to be the Securitization Fail or, in homage to Michael Lewis, The Big Fail.

Briefly, Countrywide as servicer filed a proof of claim for a mortgage in a bankruptcy case on behalf of Bank of New York as trustee for a securitization trust. The bankruptcy court denied the claim because there was no evidence that Bank of New York ever owned the mortgage. The mortgage note had never been negotiated or delivered to Bank of New York, despite the requirement to do so in the Pooling and Servicing Agreement (PSA) that governed the securitization of the loan. That meant that Bank of New York as trustee had no interest in the loan, so the proof of claim filed on its behalf was disallowed.

This opinion could turn out to be incredibly important. It provides a critical evidence for the argument that many securitization transactions simply failed to be effective because non-compliance with the terms of the transaction: failure to properly transfer the mortgage meant that the mortgages were never actually securitized. The rest of this post explains the chain of title issue in mortgage securitizations and how Kemp fits into the issue.

Note and Mortgage Transfers in Securitizations

A residential mortgage securitization is a transaction that involves a series of transfers of two types of documents: mortgage notes (the IOUs made by mortgage borrowers) and mortgages (the security instrument that says the lender may foreclose on the house if the borrower defaults on the note). Ultimately, both the notes and mortgages need to be properly transferred to a trust that will pay for them by issuing securities (backed by the mortgages and notes, hence residential mortgage-backed securities or RMBS). If the notes and mortgages aren’t properly transferred to the trust, then the securities that the trust issues aren’t mortgage-backed and are worthless.

So the critical issue here is whether the notes and mortgages were properly transferred to the securitization trusts. To determine this, we need to figure out two things. First, what is the proper method for transferring the notes and mortgages, and second, whether that method was followed. For this post, I’m going to focus solely on the notes. There are issues with the mortgages too, but that gets much, more complicated and doesn’t directly connect with Kemp.